Markets: Fixed Income
On Thursday, government bonds sold off and equities and commodities rallied higher on increasing hopes that the worst of the economic recession is behind us. Investors’ optimism was supported by the G20 agreement on fighting the global economic crisis and a decision of the US Federal Accounting Standards Board to ease mark-to-market rules. The ECB decision to cut rates by only 25 basis points instead of the widely anticipated 50 basis points rate cut along with the lack of more unconventional measures contributed to the sell-off on the European bond market, but nevertheless failed to dent investors’ optimism. The US eco data were again weak, with both initial and continuing claims setting new cycle highs, but were ignored by the market.
On a daily basis, there was a sharp bear flattening of the German yield curve, as 2- and 5-year yields increased by 18.3 basis points compared to 16.6 and 10.5 basis points in the 10- and 30-year sector. The intra-EMU spreads narrowed significantly on the back of the return in risk appetite. France was the notable exception, as it announced a new 10-year benchmark.
In the US, the yield curve shifted around 10 basis points higher with a slight outperformance of the 2-year sector (+7.9 basis points). Yesterday, the Fed purchased $7.496B of the outstanding US Treasuries maturing between 2013 and 2016. The offer/ cover ratio was the highest since the Fed started with its purchases, which added to the negative sentiment on the bond markets.
ECB delivers a double surprise
Today, all attention will go to the US where the payrolls and non-manufacturing ISM are scheduled for release. In the euro zone, the calendar contains only the final figure of the March services PMI, which is expected to confirm the first outcome of 40.1.
February’s nonfarm payrolls report came out close to expectations, showing a job loss of 651 000. The previous two figures (January and December) were sharply downwardly revised, bringing the job losses in the latest three months above 650 000 each. For March, a decline in employment by 660 000 is expected, but the ADP report showed a much larger drop in employment (742 000). Hence, following the ADP report, the market probably discounts an above 700 000 outcome. Therefore, to disappoint the market, an outcome of more than 750 000 will probably be needed. On other hand any figure of below 650 000 will be considered as a not too bad report. We have no strong reasons to distance ourselves from the consensus, as the ADP report and claims both point to another weak report. The non-manufacturing ISM is forecasted to show a marginal increase (42.0 from 41.6) in March after deteriorating slightly in the month before. A slightly higher outcome is however not excluded after the improvement in the manufacturing ISM.
On the ECB front, ECB’s Bini Smaghi will speak at a conference ‘Towards a European foreign economic policy’ organised by the European Commission. We don’t expect him to move the market, as the ECB has just held its monthly monetary policy meeting yesterday. At the meeting, the ECB governing council in essence delivered two major surprises. First, the ECB decided to cut the repo rate by only 25 basis points to 1.25% whereas a rate cut of 50 basis points was expected. Secondly, the ECB didn’t announce an extension of its refinancing operations beyond the current maturity of 6 months or any other unconventional measures. Instead, ECB’s Trichet said that the governing council will provide full details on further unconventional measures at their next policy meeting in May. Regarding the outlook for interest rates, Trichet indicated that there is still some measured room for lower rates in the repo rate, but that the deposit rate at 0.25% is probably at its low point. Whether the ECB will extend the maturity of its refinancing operations, broaden its collateral and/or start purchasing corporate bonds/commercial paper will now increasingly depend on the lending behaviour of the banking sector. In the statement, the ECB interestingly didn’t repeat that the monetary transmission mechanism isn’t significantly hampered, but suggested that both demand and supply factors have contributed to the substantial slowing in lending growth. This may indicate that the ECB is really considering the purchasing of private debt securities, like ECB vice president Papademos recently suggested. For a complete review of the ECB rate decision, we refer to the flash on our website.
Regarding trading, by leaving its options very much open, the ECB has created a lot of uncertainty. Within this environment we can expect much more volatility, but we see no reason to change track. We still feel comfortable with our buy-on-dips approach. The recent lows at 122.11/122.53 and ultimately at 120.37 in the Bund should still be considered as good entry levels to go long, while on the upside the 124.70/125.63 area has become even tougher to break above. At the short end of the curve, the ECB decision to lower the repo rate by only 25 basis points shouldn’t be exaggerated, as the deposit rate has become the increasingly important barometer for money market interest rates. Also in the case the ECB would have cut the repo rate by 50 basis points, the deposit rate was expected to fall to 0.25%. As such, we see only limited room for short-term yields to move higher and would consider current levels at around 107.82 in the Schatz as interesting levels to install new long positions. In the US, the US T-Note future has also fallen close to first important support at around 122-28+.
In the UK, the Gilt market even underperformed the German bond market on the back of another disappointing longer-term Gilt auction. Following the failed 40-year Gilt auction last week when the auction failed to attract enough bids to cover the auction, this time the bid/cover was moderate at 1.59, but the tail was very large at 4.6 basis points. This revealed that the DMO had to accept very low bids to get the issue sold.
Today, the calendar contains the services PMI. In March, confidence in the services sector is expected to show its fourth consecutive improvement. The consensus is looking for a marginal increase in services PMI (43.5 from 43.2), but the risks might be on the upside of expectations after the positive surprise in both manufacturing and construction PMI.
